HomeArticles Covenants Not to Compete And Business Acquisitions: Sound Tax Advice Can Lead to Poor Business Decisions

October 6, 2014

Covenants Not to Compete And Business Acquisitions: Sound Tax Advice Can Lead to Poor Business Decisions

By Joshua M. Dickey, Partner

Whether existing covenants not to compete (“non-competes”) will survive a business acquisition may influence the decision to proceed with the acquisition or may impact the anticipated success underlying the acquisition. Critically, the manner in which the acquisition is structured may determine the validity of non-competes between the acquired company and its employees. Thus, in Nevada, what may make the most sense from a tax perspective may not make the most sense from a business perspective.

An Example
An important client informs you that her company intends to acquire a competitor. The client explains that the primary reason for acquiring the competitor is the established relationships members of the competitor’s sales staff have with valuable customers not currently served by the client’s company. The client anticipates the acquisition will provide the company with immediate access to customers it otherwise had little chance of serving, which in turn will expand the company’s customer base and increase its revenues. The client has been advised that each member of the competitor’s sales staff is subject to a non-compete which essentially prevents him or her from engaging in the same business within the client’s sales area for a period of two years.

The client asks you for your advice on how to structure the transaction. Under the circumstances, it appears to be more advantageous from a tax perspective to acquire the competitor via an asset purchase rather than a merger. You advise the client as such, and the client, who is always in favor of minimizing her company’s tax burden, acquires the competitor via an asset purchase.

Shortly after the acquisition, three of the former competitor’s star salespeople leave the company and start their own business in competition with the company. To make matters worse, these salespeople take many of the customers they have served to their new business. These salespeople have rebuffed your client’s demands that they cease violating their non-competes, stating that they have been advised by their attorney that the non-competes are invalid as a consequence of the acquisition. Did the decision to structure the acquisition as an asset purchase undermine the anticipated benefits of the acquisition? Quite possibly.

The Basics
While it is beyond the scope of this article to explore the nuances of non-competes, some background is in order to provide context for the issue. A non-compete is an agreement in which a person or business agrees not to compete with another person or business for a specific period of time, within a specific geographic area. Non-competes typically arise as part of an employment agreement or in conjunction with the sale of a business.
There exists a common misconception that covenants not to compete are not enforceable. While this may be true in some jurisdictions, it is not true in Nevada. In Nevada, non-competes are enforceable so long as they do not impose “any greater restraint than is reasonably necessary to protect the business and goodwill” of the person or entity benefitted by the non-compete. Hansen v. Edwards, 426 P.2d 792, 793 (1967). The primary considerations in determining the reasonableness of a non-compete are (1) the duration of the restriction and (2) the geographic scope of the restriction. Id. Nevada courts have, in fact, found enforceable non-competes restricting the activities of physicians and, yes, accountants. See id.; see also Sheehan & Sheehan v. Nelson Malley and Co., 117 P.3d 219 (Nev. 2005).

Although not per se unenforceable, non-competes are disfavored by the law, and courts will strictly construe them. Consequently, care must taken by employers and sellers of businesses who desire the protection afforded by non-competes to craft the non-competes in such a manner so as to maximize the likelihood of enforcement. This is another topic altogether.

Mergers, Asset Purchases, And The Assignability Of Non-Competes
In a situation involving the acquisition of a business with existing non-competes, the structure of the transaction could determine the enforceability of the non-compete. Two relatively recent Nevada Supreme Court decisions have brought the issue to light.

In Traffic Control Services, Inc. v. United Rentals Northwest, Inc., 87 P.3d 1054 (Nev. 2004), the Nevada Supreme Court addressed whether a covenant not to compete could be assigned when a business was acquired by means of an asset purchase. The Court held that, because non-competes are personal in nature, they are “unassignable as a matter of law, absent the employee’s express consent.” Id. at 1058. Consequently, the Court held that in order for a non-compete to be assignable, there must be (1) an express clause permitting the assignment of the covenant and (2) additional and separate consideration given in exchange for the covenant itself (i.e. something more than continued employment must be given by the employer in consideration for the assignability. Ordinarily, courts will not inquire into the adequacy of consideration; as such, a nominal payment (e.g. $50 or $100) or some other additional benefit should be sufficient). Id. at 1059. Since the non-compete lacked these requisites, the Court effectively invalidated the non-compete, holding that it could not be assigned to the acquiring entity.

Five years later, the Nevada Supreme Court addressed the issue in the context of a merger and reached a different result. See HD Supply Facilities Maintenance, Ltd. v. Bymoen, 210 P.3d 183 (Nev. 2009). In Bymoen, the court recognized the “hard-and-fast distinction” between mergers and asset purchases. Unlike asset purchases, mergers are creatures of statute in which two entities effectively become one, with the surviving entity having all the contractual rights and liabilities of the entity merged into it. Based upon this principle specific to mergers, the Court held that the restrictions on the assignability of covenants not to compete applicable to asset purchases do not apply to mergers and found the non-competes enforceable.

An application of these principles to the example above reveals that the client’s tax driven decision to structure the acquisition as an asset purchase may have undermined the very purpose for the merger. Unless the non-competes contained provisions in which the (former) competitor’s salespersons agreed to the assignability of their non-competes and received independent consideration for them (provisions that are often missing from non-competes), the non-competes would be deemed unassignable and thus unenforceable by the company. This would leave the salespeople free to compete with the company and take with them the customers who were the primary reason for the acquisition.

The client potentially could have prevented the loss of these customers if the competitor had been acquired through a merger because the non-competes would vest with the client’s company regardless of whether there was a specific assignability provision and independent consideration. As indicated above, however, a merger would have caused unfavorable tax consequences.

As the above illustrates, when it comes to non-competes, good tax planning may lead to unintended, and ultimately unfavorable consequences in a business acquisition if the legal consequences of a particular structure are not considered.

This article is for general informational purposes only. It is not intended as professional counsel and should not be used as such. As legal advice must be tailored to the specific circumstances of each case, nothing provided herein should be used as a substitute for advice of competent counsel. Your use of the information contained in this article does not create an attorney-client relationship between you and the author or Bailey Kennedy, LLP.

Joshua M. Dickey is a shareholder in the Las Vegas-based firm Bailey Kennedy. His legal practice focuses on complex civil litigation, including disputes in such areas as commercial law, corporate law, business torts, and constitutional law. He is a member of the State Bar of Nevada’s disciplinary board and is on the editorial staff of the Nevada Civil Practice Manual. Reach Joshua Dickey by calling 702-562-8820 or email jdickey@baileykennedy.com.